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University of Illinois Library Urbana-Champaign at ACES BULLETIN 696 HIERONYMUS T. A. Digitized by the Internet Archive in 2011 with funding from University of Illinois Urbana-Champaign http://www.archive.org/details/managementofagri696asop 0.7 U>3 T. A. HIERONYMUS USES OF GRAIN FUTURES MARKETS IN THE FARM BUSINESS UNIVERSITY OF ILLINOIS AGRICULTURAL EXPERIMENT STATION BULLETIN 696 CONTENTS DESCRIPTION OF FUTURES MARKETS 4 HOW ONE TRADES IN FUTURES MARKETS 9 THE ECONOMICS OF FUTURES TRADING 13 CASH AND FUTURES PRICE RELATIONSHIP 22 FARMER USE OF FUTURES 53 SOME COMMON PITFALLS IN FUTURES TRADING 71 APPENDIX TABLES 73 This bulletin was prepared by T. A. Hieronymus, Professor of Agricultural Marketing. Urbana, Illinois September, 1963 Publications in the Bulletin series report the results of investigations made or sponsored by the Experiment Station FARMERS OFTEN INDICATE AN INTEREST IN GRAIN FUTURES MARKETS, both a general interest in how futures influence the price and marketing of grain, and a specific interest in how they can use futures in their farming operations. Futures markets are advanced and sophisti- cated systems of trading in contracts for deferred delivery, and a fairly high level of knowledge about them is necessary if they are to be used effectively. At the same time they are basically simple exchange markets that evolved out of existing commercial needs. The acquisition of enough knowledge to use futures markets is neither a long nor a difficult process. The information contained in this bulletin will give the farmer both a basic and detailed understanding of the futures markets, and will tell him how he can make effective use of these markets in connection with his farm business. There are principally four ways in which farmers can use futures markets in their farm businesses: 1. To fix the price of a crop before harvest. At any time from before planting until harvest a farmer can fix, within narrow limits, the price that he will receive at harvest by selling futures contracts in an amount equal to the quantity of the crop that he expects to produce. In a sense, futures markets offer farmers an opportunity to produce on contract at guaranteed prices. 2. To fix the price of grain in storage for later delivery. The futures market effectively bids for grain that will be delivered at various times in the future. Typically these bids are higher as the time of delivery is more distant. Thus farmers, by selling futures contracts, can accept the current market price and yet retain possession and be paid for storage. 3. To fix the cost of feed without taking immediate delivery. Feed- ers can cover forward requirements by buying futures contracts. They will, however, indirectly pay someone else to store the feed grain until they are prepared to accept delivery. 4. To speculate in the price of a crop that has been produced but for which storage is not available. Frequently farmers wish to retain ownership of a crop that they have produced even though they do not have or cannot obtain storage space. They can do so by selling cash grain and replacing it with futures. However, the increase in the futures price is typically less than the increase in the price of the cash grain. If the price of the grain goes down, the futures will go down 4 Bulletin 696 [September, more than the cash. If the change in the general level of price is small, the futures may actually go down while the cash price is going up. Thus, indirectly, farmers pay someone else to store for them when they replace cash with futures. The key to understanding futures markets may be had through the study of basis. Basis is the difference between cash and futures prices. Typically the cash price increases in relation to the futures as the storage season progresses. This narrowing of the basis is equal to the going market price for storage. The behavior of the basis is fairly consistent from year to year. It is possible to anticipate basis behavior during periods in the future and thus read from futures prices the prices that can be received for cash grain (for later delivery) if offsetting futures positions are taken. Futures markets are not used extensively for transfer of title. Farmers should never trade in futures expecting to make or take delivery. Rather, they should separately trade in futures and apply profits or losses to the prices received and paid in their usual trans- action at local elevators. In our discussion we shall proceed through six steps: (1) description of futures trading, (2) information about how one actually trades, (3) the economics of futures trading, (4) cash and futures price relationships, (5) the uses farmers can make of futures, and (6) some common pitfalls in futures trading. DESCRIPTION OF FUTURES MARKETS Futures trading is authorized for many commodities and on several exchanges. The principal United States exchanges and the commodities traded in them are as follows: Exchanges Commodities Chicago Board of Trade Wheat, corn, oats, rye, soybeans, lard, cotton, cottonseed oil, soybean oil, grain sorghums, soybean meal Chicago Mercantile Exchange Butter, eggs, potatoes, frozen broilers, . . frozen turkeys Chicago Open Board of Trade. .Wheat, corn, oats, rye, soybeans Commodity Exchange, Inc., New York Burlap, copper, hides, rubber, zinc 1963] Grain Futures Markets in Farm Business 5 Kansas City Board of Trade. .Wheat, corn, grain sorghums . . Memphis Board of Trade Cottonseed meal, soybean meal Milwaukee Grain Exchange. .. .Wheat, corn, oats, rye Minneapolis Grain Exchange. .Wheat, oats, rye, soybeans, flaxseed . New Orleans Cotton Exchange Cotton New York Cocoa Exchange. .Cocoa . . New York Coffee and Sugar Exchange Coffee, sugar New York Cotton Exchange Cotton . . . New York Mercantile Exchange Potatoes, eggs, butter New York Produce Exchange. .Cottonseed oil, soybean oil Seattle Grain Exchange Wheat St. Louis Merchants Exchange. .Millfeed Wool Associates of the New York Cotton Exchange Wool, wool tops With regard to the grains, the Chicago Board of Trade is by far the largest market. Kansas City and Minneapolis, as well as Chicago, are important wheat futures markets. Nearly all of the futures trading in the other important Illinois-produced grains (corn, soybeans, oats) is conducted at Chicago. A Futures contract futures contract is an agreement between two members of an exchange to buy and sell at a specified time in the future an agreed amount of a commodity at an agreed price. This contract for deferred exchange may or may not be finally consummated by an exchange of title. It is nevertheless a firm and binding agreement. The contracts are highly standardized so that most of the terms are understood and trading can proceed with a minimum of negotiation and great rapidity. The standard unit of trading is 5,000 bushels of the major grains. These contracts may be subdivided into smaller units for the benefit of people who wish to trade in units of less than 5,000 bushels. These "job lots" are in multiples of 1,000 bushels for corn, soybeans, and wheat, and multiples of 2,000 bushels for oats. The unit of trading is ]/& of a cent. This amounts to $6.25 per 5,000-bushel contract. Bulletin 696 [September, There are various delivery months authorized for trading. These have been adopted over time out of existing trade practices. For the four principal grains they are: Corn Oats Wheat Soybeans December July July September March September September November May December December January July March March March September May May May July August It is desirable that the months of trading be restricted to less than 12 so that trading does not become spread over so many months that market liquidity is reduced. The selection of the various months is logical. For example, July is the main month of winter wheat harvest, September is the main month of spring wheat harvest, December is the last month of navigation on the Great Lakes (an important method of wheat movement), March is the first month in which navigation is open on the lakes, and May is the last month before new crop harvest. For each trade the quantity, the month of delivery, and the price must be agreed upon by negotiation between the two principals. The rest of the terms of the contract are uniform for all contracts and are understood. Delivery is to be made at any time in the delivery month that the seller elects, from the first day to the last. Delivery is made in store in any one of several public warehouses designated as "regular" by the Chicago Board of Trade and located in the rail switching district of Chicago. An exception to this rule is that delivery may be made, again at the option of the seller, in railroad boxcars during the last three business days of the delivery month. No. 2 grade is the quality traded. There are premiums and dis- counts (fixed by the exchange) if the seller elects to deliver a higher or lower grade. The terms of payment are cash on delivery of ware- house receipts. No credit is extended on futures trading. Pit trading Trading on the Chicago Board of Trade is done in pits. These are hexagonal structures with steps that lead down into the center. This arrangement results in maximum visibility for all of the traders. The place where each trader stands indicates the delivery month in which he is primarily interested in trading. Bids and offers are cried out in a sufficiently loud voice for all to hear. The result is that there is sometimes so much noise that few can hear and trading is actually done by a system of hand signals. Each